IRS Issues Guidance on the Deduction for Domestic Production Activities

On January 19th, the IRS issued guidance on the phased-in deduction for qualified domestic production income that was enacted last October as part of the American Jobs Creation Act of 2004. The deduction is effective for taxable years beginning after December 31, 2004. The new guidance is meant to assist taxpayer-employers in implementing the new provision until regulations are issued.

The new deduction is equal to 9% (3% in the case of taxable years beginning in 2005 and 2006, and 6% for taxable years beginning in 2007, 2008, or 2009) of the lesser of (a) the qualified production activities income (QPAI) or (b) taxable income determined without regard to the new deduction.

Qualified Production Activities Income

Qualified production activities income (QPAI) is defined as domestic production gross receipts (DPGR – gross receipts from any lease, license, sale, exchange, or other disposition of qualified production property) less the sum of (1) cost of goods sold that are allocable to DPGR; (2) other deductions, expenses, and losses that are directly allocable to DPGR; and (3) a ratable portion of other deductions, expenses, and losses that are not directly allocable to DGPR or another class of income. QPAI is determined on an item-by-item basis, rather than on a transactional or product basis.

Qualified Production Activities include:

The manufacture, production, growth, or extraction in whole or significant part in the United States of tangible personal property (e.g., clothing, goods, and food), software development, or music recordings (not contract manufacturing);

Film production (with exclusions specified in the statute), provided at least 50 percent of the total compensation relating to the production of the film is compensation for specified production services performed in the United States;

Production of electricity, natural gas, or water in the United States;

Construction or substantial renovation of real property in the United States, including residential and commercial buildings and infrastructure such as roads, power lines, water systems, and communications facilities; or

Engineering and architectural services performed in the United States and relating to construction of real property.

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Allocating Cost of Goods Sold and Other Deductions

Two methods have been provided for allocating deductions (other than cost of goods sold) to qualified production activities. The first method is available to all taxpayers. The second method is available to taxpayers with average annual gross receipts (over the three prior years) of $25 million or less. Further, the second method provides a simplified formula that allocates deductions based on the ratio of the taxpayer’s receipts derived from qualifying production activities as compared to the taxpayer’s receipts from all sources. Finally, a third allocation method is available for taxpayers with average annual gross receipts of $5 million or less. Additionally some small taxpayers are permitted to use the cash method of accounting.

Wage Limitation

The deduction is limited to 50% of the W-2 wages paid by the employer during the year. "W-2 wages" are defined as the sum of wages and elective deferrals that must be reported on Forms W-2. The new guidelines provide 3 alternative methods for computing W-2 wages.

Partnerships and S Corporations

The deduction attributable to the qualifying production activities of a partnership or S corporation is determined at the partner or shareholder level. As a result, each partner or shareholder must compute its deduction separately.